The trouble with bond indices

Is your bond ETF exposing you to the weakest links?

September 2, 2015

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Bond exchange-traded funds (ETFs) have been one of the fastest-growing segments of the ETF landscape, driven largely by institutional investors seeking liquid access to fixed income. According to a recent study by Greenwich Associates 59% of institutional fixed income ETF users have increased their use of bond ETFs since 2011 and 40% plan to increase their allocations in the year ahead.

Bond ETFs have also been under the microscope all summer, with Carl Icahn facing off with Larry Fink about potential liquidity issues and Janus Capital’s Bill Gross also sounding off about potential issues in the space.

Liquidity has been an important part of the ETF conversation especially as institutional investors come to rely more and more on fixed income ETFs in their portfolios (according to that same Greenwich study, 55% say liquidity is their top driver of fixed income ETF use).

But while much-needed attention is being paid to liquidity, there’s another piece of ETF mechanics investors ought to be aware of—the underlying index. A good article in the Financial Times (subscription required) a couple of weeks ago unpacks some of the key issues with many bond indices.

As Robin Wigglesworth reports, there is a world of difference between the average stock index and bond indices. Most of us already know that equity indices are driven by size—companies like Apple for example can have an outsized impact on how an index performs. That’s why so many investors are looking to get around the size effect through factor indices like value and momentum.

But what about the growing universe of bond indices? This is where weak links often drive how an index performs. Wigglesworth points to the fact that the U.S., Italy and Japan make up more than half of the US$42.5 trillion Barclays Global Aggregate universe, which is the main international bond gauge. Brazil, Russia, India and China make up a lowly 1%. So, the most indebted bond markets rule—and that can put investors at a disadvantage.

Same goes for national and industry-specific indices. Wigglesworth points out that U.S. Treasuries and agency bonds make up nearly 70% of the Barclays U.S. Aggregate index. That is bad news for investors especially with a rate hike on the horizon.

So what does this mean for ETF investors? On the equity side, there are already many ways to get around the flaws in major indices—but what about bond investors? This is where unconstrained bond funds are making headway, especially in the institutional space—money managers have launched several new products over the last few years, particularly in the pension space where interest rates are a huge risk.

On the ETF side, however, there has been much less discussion about how to get around the flaws in major bond benchmarks. Pimco’s ETF version of its Total Return Bond Fund was an early foray—but how have ETF providers fared in creating additional opportunities? ETF Trends’ Tom Lydon points out a few including the SPDR DoubleLine Total Return Tactical ETF and the WisromTree Western Asset Unconstrained Bond Fund.

But for Canadian plan sponsors, the topic raises interesting questions about the increasing exposure to bond ETFs and potential risks in the underlying indices. Can a new set of ETFs help manage these risks—and would they be appropriate for pension funds?

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